The inevitable

“At some point it will become clear, even to the “America is BOOMING” crowd that the Fed’s next move will be a rate cut. The double-talk and excuse making will be a thing of beauty.” — Omniscient blog dog

Will interest never go up again?

That’s the meme among the moisters, doomers and the dearly-indebted who’ve convinced themselves the cost of money will not rise because (a) the government would never dare, (b) everybody would be screwed, (c) housing would crash, (d) the economy would seize up, then croak, (e) the US is a failed state about to be run by (pick one) a criminal or a psycho and (f) it’s, like, unfair – that’s not why we elected Justin!

Well, guess what. Rates will go up. It’s absolutely inevitable. The only uncertainty is the schedule. Here’s a likely scenario: the US Fed hikes on December 14th, then twice during 2017, and more frequently thereafter. Remember, the average tightening cycle by the US central bank involves 10 to 12 increases and lasts up to four years.

As for Canada, the central bank here follows the Fed lead 93% of the time, and ditto for the bond market. Given our flaccid economy, there could be a lengthy lag between them and us, but it’ll come. If you’re pickled in epic levels of debt (recall that four in 10 buyers of $1 million+ houses in Toronto have debt equaling at least 450% of income) you have a unique window of opportunity to get ready. If you ignore it, good luck.

Here’s why central banks in both countries will surprise you.

First, it’s been eight years since anything was normal. Almost a decade of in-the-ditch rates succeeded in avoiding the deflation and depression that threatened us in 2008, but with unintended consequences. The effectiveness of cheap money (in stimulating growth) has worn off. Inflation has crept back into the picture. Assets bubbles have formed (look no further than Canadian real estate). Governments, corps and especially households have become indebted as never before. In fact a whole new generation has grown up with no fear of borrowing. Low rates now threaten to turn into a negative, rather than a positive.

This means rates must rise. If not, inflation will advance, putting pressure on wages and prices. Asset bubbles could inflate then erupt, with dire consequences. And should conditions worsen, central banks would be unable to lower rates as a temporary stimulus, since they’re already close to zero.

Second, unelected central bankers are running the global economy because too many weenies, populists and milquetoasts hold political office. Low rates alone cannot blow wind into an economy, nor can spending cuts and balanced budgets work when deflation threatens. There’s a role for government in days like these, to spend big on infrastructure, job creation and public assets. T2 got elected on exactly such a promise, for example. Thus far, nothing.

So long as central banks continue to shovel out nearly-free money, governments are less likely to enact fiscal stimulus (as opposed to CBs’ monetary stimulus).

This brings us to Brexit, Trump and the anti-globalization sentiment now sweeping western society. Both US presidential candidates are promising massive spending, so it’s a certain bet the pressure will be off the Fed starting in 2017, making rate hikes far more likely. But there’s more.

Trump would build walls insulating America from its neighbours, rip up established trade agreements (like NAFTA) and withdraw from foreign alliances. Make America Great Again is code for getting a country which is more homogenous, nationalistic and independent. Britons voted themselves out of Europe for the same reasons. And all of that is intensely anti-global and anti-free trade.

Why does this matter to the cost of your mortgage?

Because free trade and porous borders, outsourcing jobs and filling Wal-Marts with crap from China has helped keep inflation low, prices falling, wages depressed and supported the cheap cost of money. Brexit will change some of that. Trump’s changing more. And across Europe there’s a growing tide of rightist emotion that will push the agenda ahead.

The bottom line, as stated here yesterday, is that we probably at, or close to, the bottom in terms of the cost of money. It’s seriously naïve to think the Bank of Canada will slash its key rate further, or to believe the Fed won’t resume its stated course of normalization. No, rates aren’t going to back to levels of a decade or two ago. But they will be doubling.